Commercial real estate investing is the natural progression from residential real estate investing. Savvy real estate investors tend to move into commercial real estate sooner rather than later, and for very good reason.
Once your portfolio grows, it will be very difficult to manage your investments if a large part of them is tied to residential properties. Imagine if you have $15 million worth of residential property. There will be many homes and tenants to take care of.
On the other hand, $15 million will buy only a very small number of commercial properties that will be comparatively easy to manage with much lower overhead.
Commercial properties include offices, industrial sheds, independent retail stores, bulk retail stores, store blocks, medical centers, gas stations, motels, hotels, backpackers, gyms, churches, funeral homes, day care centers, car yards, convenience stores . , malls, to name just a few. Each type of commercial real estate investment has its own quirks, strengths, issues, rewards, and risks.
The return on investment in commercial real estate is much higher than residential property. Income is also more stable due to long leases.
It is typical to have returns of around 10% net for a commercial real estate investment and between 7% and 9% net return for a prime property.
The value of commercial real estate is largely determined by the quality of the lease. In general, the value is determined by taking the net contractual rent that is paid and using a capitalization rate to arrive at a value. The value is also determined by the quality of the tenant and the length of the lease.
The value of a commercial property can drop substantially if it becomes vacant. I have seen commercial properties sold for less than half their value if they are difficult to lease.
Commercial property management is also much simpler because tenants have a strong vested interest in maintaining the property to a high standard. Tenants generally derive their income from the property. They have to keep the property in good repair and maintain functionality to impress their clients.
I have seen renters spend millions of dollars to make improvements to the property. Most of these improvements remain on the property long after the tenant has moved out.
Real estate law is more flexible towards commercial leases. You can draft and add virtually any clause that is acceptable to the contracted parties. It is common to charge default interest on rent owed or close the premises in the event of continued non-payment of rent.
By far the biggest risk in commercial real estate investing is finding a new tenant in the event of a vacancy. In commercial real estate, each tenant’s requirements in terms of size, location, use and ability to pay rent are so different that it is very difficult to find the right tenant for the right property.
For the reasons mentioned above, it is also difficult to sell a commercial real estate investment. Higher the value of the property there are fewer investors to buy the property. A commercial real estate investment is less liquid than other investments because there are so few players in the market. For a residential home there will be hundreds of potential buyers, which is not the case with commercial properties.
Commercial real estate investments are generally sold at capitalization rates and rarely at replacement value. Therefore, it is possible to purchase a poorly leased commercial property for well below its market value. You can also increase the value of your commercial real estate simply by raising rents during rent reviews or by renegotiating lease terms when it’s time for renewal.
The financing of commercial real estate investments is more difficult to obtain, since the banks analyze the quality of the tenants, the duration and the conditions of the lease. They will typically finance a maximum of 50% to 66% of the property’s market value. Loan rates are also marginally higher. Therefore, you will need more capital to buy. This reduces your leverage power to buy more properties.
Commercial real estate is where professional investors put their energy due to the higher returns and ease of management. For these investors, commercial property is their ‘bread and butter’ and they earn their speculative income by trading residential properties.
Some commercial investors focus their attention on improving and adding value to their commercial portfolio. While others use their rental income to fund development projects that show much higher returns but need different and more advanced skill sets.
Investing in commercial property is very rewarding but requires more knowledge, experience and capital outlay. It’s wise not to jump into commercial real estate early on until you have the knowledge, very deep pockets, and the ability to take risks. It is advisable to start with a residential real estate investment to build your capital and cash flow.
You should purchase at least 8-10 residential investment properties before venturing into the world of commercial real estate.